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How Patient Should Offshore Drilling Investors Be?

Offshore drillers have been hit hard in the last six months. How patient should investors be in waiting for a turnaround?

The oil and gas industry has been fickle recently, leaving many shareholders concerned with the future of the industry and its probability to rebound.

As Energy Transfer Partners(NYSE:ETP) offers unsolicited buyouts, other companies are left envious regarding the potential opportunity to grab a quick buck. Yet some companies are still drilling with archaic equipment, with no plans to upgrade, affording ETP the opportunity to stay ahead of the competition. Will this force others to step up their game, or will some be left in its wake?

A full transcript follows the video.

Sean O'Reilly: How patient should investors in offshore drilling be? On this energy edition of Industry Focus.

Greetings, Fools! I am Sean O'Reilly joining you here from beautiful Alexandria, Virginia, at Fool headquarters. To my left is the incomparable Tyler Crowe. How are you, sir?

O'Reilly: I am sorry for missing last week's episode. I was on the sunny beaches of Florida, but I also wanted to congratulate you on...

Crowe: I wouldn't say I was "missing" you, Sean.

O'Reilly: Well, I do want to congratulate you on getting hitched recently.

Crowe: Thank you very much. It was a good time.

O'Reilly: Your poor wife.

Crowe: Yeah. I'm sure she's suffering already.

O'Reilly: Today, first and foremost I wanted to talk about a little bit of news. It seemed odd to me because it seemed like more money than the stock's ever traded for, but Williams Cos.(NYSE:WMB) has rebuffed a $64-a-share buyout offer from competitor Energy Transfer Partners LP. I looked at their 52-week high from last year when oil was at $100, and it was $61.

They're saying the $64 offer drastically undervalues the company and the value they expect to realize with all these projects. It seems a little optimistic to me based upon future estimates of earnings and all this. Why am I wrong? What do you think?

Crowe: I don't necessarily say you were wrong. One thing to consider when we're looking at this is, this was an unsolicited offer. This is like somebody walking up to you on the street and saying, "I want your jacket off your back right now. I will give you $250 for it."

O'Reilly: I would be like, "Why?!"

Crowe: Exactly. I have no insider information on this. I want to be clear with everybody. When I hear it was an unsolicited offer I get the feeling it's the same thing. Energy Transfer walks in and says, "I'm going to give you $64 per share for what you guys own." And they're like, "Uh, I don't know... uh... I'll get back to you on that." Immediately afterward they started saying, "We're going to reassess what this is." They say that [it's] because it was undervalued.

O'Reilly: That's just the negotiation tactic.

Crowe: It sounds like a negotiation tactic, if you ask me. If you look at the deal itself, it looks pretty damn good for a shareholder of Williams Co. Not just Williams Cos., but also Williams Partnership. Part of this deal that Energy Transfer is saying they want to buy Williams Co. is saying "You have to stop your acquisition of your partnership." The current plan for Williams Cos. right now is to buy the remaining shares of its partnership and lower its cost of capital and make it more of an efficient operator.

O'Reilly: Restart the clock on the depreciation.

Crowe: Restart the clock on the depreciation -- all those cool things that we talked about a little while ago -- but Energy Transfer says, "No. We like incentive distribution rights." If you look at the model they have done over the years with Energy Transfer Partners, with Sunoco Logistics Partners and every other MLP they have ever purchased, the parent company -- Energy Transfer Equity -- doesn't want to own any shares of the limited partner.

It will normally trade them down and give them back to Energy Transfer Partners, or give them back to somebody else and say, "You can have them. We just want the incentive distribution rights." It's a great way of owning nothing and getting a ton of money for it. As part of this deal with Energy Transfer Equity, they are saying to Williams Partners, "Stop your deal to buy out your limited partnership, and we will absorb you as is and let people of Williams Partners keep that position as a limited partnership."

For anybody who's a unitholder of Williams Partner[s], this actually looks cool. If the deal goes through where they have to be acquired by Williams Cos. they will have to trade up from MLP to a C Corp, which means they invoke the wrath of the tax man.

O'Reilly: Naturally.

Crowe: From a unitholder's perspective, it looks good to take the Energy Transfer deal. At the same time, if you're Williams Cos., this thing is a lot of money.

O'Reilly: I've been looking at the stock and investors don't seem to think it's going to go through. It's at $57, they were offered $64; theoretically, Williams is going to ask for more. So let's call it $70.

Crowe: Even still, if it was at $70; that's a lot of money. That is a lot of money for the stock.

O'Reilly: If you're looking at the earnings, it's trading at 20 times. We can go in and out about gap.

Crowe: I don't like to use earnings when it comes to messing with limited partnerships and stuff like that. I think one of the best ways to look at this is actually price-to-tangible book value.

O'Reilly: OK.

Crowe: If you look at it right now, I believe it's more than 12 times. If you were to use that $64 purchase price, that's more than 12 times tangible to book value for Williams.

O'Reilly: That sounds like a win to me.

Crowe: That's a lot of money. That's a pretty high valuation. If you look at the earnings power, or the EBITDA power -- the cash flow power -- of Williams Co. and the projects it has coming over the line for the next couple years, if we were to use that $64 share price point and compare it on an enterprise value EBITDA to its current peers in the space, it would basically take them until their EBITDA estimates were somewhere in the 2018, 2019 range until it gets back into that valuation range...

O'Reilly: Finance 101. If one of my finance professors from college were here, he would say, "You have to discount that, of course, at a reasonable interest." 7%, or 8%.

Crowe: It's a really good deal. I'm wondering why they turned it down.

O'Reilly: Yeah.

Crowe: More than anything, I feel like it just threw them for a loop. It was that unsolicited deal that Energy Transfer ran into the CEO and said, "I will give you $64 now!" and they were like, "I'm still wearing the coat! I don't know what to do!"

O'Reilly: Make sure there's nothing valuable in the pockets and give it to them.

Crowe: "What if it rains while I'm still out?"

O'Reilly: Good stuff! Well, the big news of today that I really want to talk about -- because it's a really interesting point -- is all this debate about how long oil prices are going to stay low. It's still at $60. We were at $100 eight months ago. A lot of projects, particularly offshore ones -- you're talking five, 10 years of planning, development, and that's where we're finding the biggest deposits of oil these days.

I was very curious to see where you think the offshore rig drillers are positioned going forward. These stocks have been decimated, but if you take a step back and think, "Where are we in five years?" That's what actually matters with these guys. Is it that bad?

Crowe: That's a really loaded question, isn't it? Good thing we have plenty of time, right? Plenty of time?

O'Reilly: I've got about 10 minutes left.

Crowe: Oh, man. 10 minutes? OK. If you look at what people are saying -- you look at industry analysts, you look at executives, you look at anybody in the space right now -- they're basically saying, "Come mid-2016, we're still going to be on the decline in the offshore oil rig market."

O'Reilly: In terms of rates.

Crowe: In terms of rates, in terms of companies not wanting to put on a whole bunch of new contracts during that time. They want to see how everything shakes out. Obviously, with oil prices where they are, it's not the best time to be exploring and producing, or developing projects offshore because it doesn't seem as lucrative. At the same time, when you're developing those projects, you can't be basing it on today's oil prices entirely, because five years from now we can't assume that...

O'Reilly: And a lot of these guys have backlogs, right?

Crowe: Right.

O'Reilly: To the bearish case of credit, companies have been slashing capital budgets, but they haven't been slashing these offshore multiyear things. It's more of the domestic North American land-based stuff.

Crowe: Yeah. Those are the easy things to cut quickly, right now. If you look at a lot of companies that drill offshore, they're not highly reactive. "Oh, man! Oil prices are going down, we have to slash our budgets to bargain-basement prices." You're looking at national oil companies and you're looking at the integrated majors. The ExxonMobils of the world; somebody like that. When you consider that, they're a little more patient.

They're going to tone things down a little bit, trim a bit off the edges where they're like, "We don't have to start this project today. We can move it a year from now." And they'll be OK. In large part, I think one of the things they're really looking for is seeing what they can get out of these people and they understand that it might take a bit more than a year to get that out of them. One thing that has happened recently -- if you look at someone like Transocean(NYSE:RIG) -- they saw a bunch of contract extensions on some of their existing fleet. Basically, things they have on the water today have been getting three-, five-, and six-month extensions on things. Ensco(NYSE: ESV) saw some similar results.

O'Reilly: That sounds good. Am I wrong?

Crowe: That sounds good. It's not great. Basically, it's a way of a national oil company testing the waters a bit.

O'Reilly: Oh, it's stringing along a bit to see -- yeah.

Crowe: Stringing along, saying "We're not going to start a new project where we need one of your new rigs and establish a new contract. We're just going to keep this one working a bit longer. It's already money we're spending and we can do it more efficiently because we'll keep your rig working if you're willing to take $10, $20, $30 thousand a day off that dayrate." We saw that on some of the recent contracts. Nobody's really doing anything big. Nothing too aggressive. Until we see that major asset turnover -- which we're going to see because there's a lot of old rigs out there that are going to go away.

They've got to make space for a lot of these new rigs that are under construction. Once that goes away and demand for oil and price of oil goes back up a bit more -- we anticipate that it will go back up, there's no guarantees -- but there's a good chance it will based on where it is today. If that were to happen, then we could start to see those contracts start to get filled again.

O'Reilly: What's this I hear about the Transoceans of the world that have really old fleets that need to go away, and guys that have brand-new technology, and the pricing starting to become two-tiered? How worried should I be if I own some of these older fleets? That sounds bad.

Crowe: It depends not only on the age of the fleet, but how the company plans to deal with that fleet. Transocean has a lot of really old things.

O'Reilly: I don't mean to pick on anybody, but that just popped to mind.

Crowe: They have a lot of older rigs, but at the same time they have a lot under construction, and they appear to have a clear path of "We are going to get rid of these old rigs." They have announced plans to scrap 20 rigs off their current fleet in order to make room for these new ones. They don't really see the necessity of hanging on to them for much longer. The former National Oilwell Varco CFO has taken a leadership position at Transocean, and that's been one of his big things: cost-cutting and managing that fleet.

He's getting it ready for the next wave. That is a bit more commendable than someone who has an old fleet that doesn't really seem to have a clear path forward with new ones. Maybe I'm pointing fingers too much, but I'm looking at someone like Diamond Offshore (NYSE:DO). Older rigs, no real plan to bring on any new ones...

O'Reilly: Just crossing your fingers?

Crowe: Yeah. They've done a lot with revamping older assets and keeping them working for a long time, but you can only do that for so long. You can only take so many puffs off the butt of a cigar before it goes away.

O'Reilly: The big majors that are paying these people the day rates can be pickier and say, "Well, we'd really like the newer one." Right?

Crowe: Yeah. Why not? I think most recently [ASHA] said the global utilization rate of deep, offshore rigs is -- including everybody, not just the companies that we talk about. There's a whole bunch of private companies and companies that are not traded on the U.S. stock exchange. If we were to look at the whole global fleet we're talking utilization rate in the 50s. Which is quite low. It's a buyer's market.

O'Reilly: Yeah.

Crowe: If I'm looking at that and I see I can get a rig for $100,000 less than six months ago, maybe if I wait a little longer I can get an extra $50,000 off.

O'Reilly: Then you start stringing people along for six months.

Crowe: Stringing people along a bit longer. So, if I am an investor looking at this space there are a couple things you have to consider. You have to consider time horizon. If you're only in this for one or two more years -- maybe someone coming up on retirement, or someone who's paying dividends saying, "This looks like a decent dividend, I can hang on to this for one or two years and get some income payments" -- I wouldn't be too certain on that.

The next two to four years looks much less certain. However, if you look out on the long-term time horizon, oil and gas production from the offshore region is going to be a growing portion of total oil and gas production. We talked before the show about Russian Arctic oil. It's going to play a large component of it. Further deep offshore...

O'Reilly:Shell's doing that through the Obama administration.

Crowe: Shell is doing it, ExxonMobil has been trying for years to work with Rosneft -- although, with the sanctions it's a little tough. Offshore Africa is looking huge, both west for oil and east for natural gas. There's still a lot of oil left in the Gulf of Mexico, and if Brazil can ever get its act together with Petrobras, there's a ton of oil there, too. So it's going to play a growing role in overall production and we're going to need these rigs five, 10 years from now. If you're willing to wait out the commodity cycles -- which can take a long time -- there is a lot of potential there, especially if you look at the way some of these companies are priced today. However, you have to realize that you're going to be riding a really, really long bet on this one. Going into it, be ready to wait a very long time. Don't get too antsy with it.

O'Reilly: Very good. Well, thank you for your thoughts, Mr. Crowe. That is it for us, Fools. Before we go, I want to make everybody aware of a very special offer for all of our Industry Focus listeners. If you found this discussion informative, and you're looking for more Foolish stock ideas, Stock Advisor may be the service for you. It is our flagship newsletter started more than 10 years ago by Motley Fool co-founders Tom and David Gardner. We're offering the lowest price out there for all of our Industry Focus listeners. It is $98 for two a two-year subscription to Stock Advisor.

You will get two stock recommendations every month with insight from our team of analysts. Just go to focus.fool.com to take advantage of that deal. Once again that is focus.fool.com. If you have any questions or comments, feel free to email us at if@fool.com. We would love to hear from you. As always, people on this program may have interests in the stocks that they talk about, and the Motley Fool may have formal recommendations for or against those stocks. So, don't buy or sell anything based solely on what you hear on this program. That's it for us, Fools! For Tyler Crowe, I am Sean O'Reilly. Thanks for listening, and Fool on!